RESOLUTION AND REALITY

In October, U.S. equity markets fell for the first time in five months. The decline was mild; the S&P 500 returned -1.85%. Black Cypress equity portfolios were down just 1.03%.

Our portfolio continues to yield more, to trade at multiples below, and to contain higher quality businesses than that of the S&P 500. Over the long-term, we should expect our value approach to significantly outperform during market declines, outperform during flat to moderately rising markets, and to underperform during richly valued and speculatively driven markets. Since inception, our securities have outperformed the S&P 500 by more than 1.60% per year with less volatility and while taking on less risk. This feat is all the more respectable due to the fact that the S&P 500 is up over 16.00% per year amidst historically rich valuations. We have delivered outperformance in an environment that has–theoretically at least–not been suited to our approach. We remain well-positioned for whatever the economy or politics throws at us.

As has been the case for months, economic data has been positive but subpar. The October employment situation report was heralded as an affirmation to a strong economy. In our opinion, the report was mixed. Payroll employment is at best a coincident indicator. Non-farm private sector employment rose 184,000 during the month, the largest increase since February. The leading indicators of the employment report, including hourly earnings, hours worked, and weekly earnings, all fell during the month. Also, our proprietary measure of the economy’s earnings fell into recession territory. One report does not make a trend, but by no means is the employment situation report as positive as some claim. Core capital expenditures, also known as durable goods less defense and airplanes, have also been plumbing recessionary levels.

Some economic data is robustly positive. Housing has been recovering, with prices up and construction rising. Auto sales continue to climb. The money supply is expanding and bank lending, while still too tight, has been growing. These are very positive for current and future economic growth. So while all is not well, there are still too many positives, in our opinion, to worry about recession just yet.

Furthermore, at least part of recent weakness is due to our government’s inability to strike a compromise on the fiscal “cliff”. Fortunately, we had a conclusive victory in the Presidential election, so the only U.S. unknown remains the ultimate direction of taxes and government spending. We continue to expect some resolution, or at least still hold hope in our country’s leaders. It is apparent to us that it makes zero sense to not compromise; taxes are going to rise anyway, spending cuts are automatic, and a recession created by Congress will surely lead to severe election losses in 2014.

A resolution to the cliff will likely be met with an equity market advance. Two things are worth noting. One, any resolution will entail tax increases and cuts to spending, both of which will be additional drags on an already weak economy. Austerity slows GDP growth. We cannot avoid this, however, as the long-term U.S. fiscal situation demands restraint. Two, valuations on broad equity markets are historically expensive. You wouldn’t be able to tell that based on the forward P/Es (quoted somewhere between from 12 to 14x) that are constantly discussed by analysts and financial reporters. The facts are, profit margins are hovering around historical highs and more recently, earnings have actually declined year-over-year when adjusted for inflation. The trillion dollar deficits that the U.S. has run for the last few years have been very favorable to corporate profit margins, the former of which is supposed to be cut substantially over the coming years. No doubt that will have an impact on profit margins.

There is no guarantee that the above will slow the market’s ascent. However, it is our unfortunate reality and we must guard ourselves and our positioning from the most likely future: slow economic growth and below average broad market returns.